DIVORCING MONEY FROM MONETARY POLICY

Economic Policy Review - Federal Reserve Bank of New York, Sep 2008 by Keister, Todd, Martin, Antoine, McAndrews, James

Recently, attention has turned to an alternative approach to monetary policy implementation that has the potential to eliminate the basic tension between money and monetary policy by effectively "divorcing" the quantity of reserves from the interest rate target. The basic idea behind this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. Under this system, the interest rate paid on reserves forms a floor below which the market rate cannot fall. The supply of reserves could therefore be increased substantially without moving the short-term interest rate away from its target. Such an increase could be used to provide liquidity during times of stress or to reduce the need for daylight credit on a regular basis.2 A particular version of the "floor-system" approach has recently been adopted by the Reserve Bank of New Zealand.

It should be noted that adopting a floor-system approach requires the central bank to pay interest on reserves, something the Federal Reserve has historically lacked authorization to do. However, the Financial Services Regulatory Relief Act of 2006 will give the Federal Reserve, for the first time, explicit authority to pay interest on reserve balances, beginning on October 1, 2011. A floor system will therefore soon be a feasible option for monetary policy implementation in the United States.

In this article, we present a simple, graphical model of the monetary policy implementation process to show how the floor system divorces money from monetary policy. Our aim is to present the fundamental ideas in a way that is accessible to a broad audience. Section 2 describes the process by which monetary policy is currently implemented in the United States and in other countries. Section 3 discusses the tensions that can arise in this framework between monetary policy and payments/liquidity policy. Section 4 illustrates how the floor system works; it also discusses potential issues associated with adopting this type of system in a large economy such as the United States. Section 5 concludes.

2. AN OVERVIEW OF MONETARY POLICY IMPLEMENTATION

In this section, we describe a stylized model of the process through which many of the world's central banks implement monetary policy. Our model focuses on the relationship between the demand for reserve balances and the interest rate in the interbank market for overnight loans. Following Poole (1968), a variety of papers have developed formal models of portfolio choice by individual banks and derived the resulting aggregate demand for reserves.3 Our graphical model of aggregate reserve demand is consistent with these more formal approaches. We first discuss the system currently used in the United States and then describe a symmetric channel system, as used by a number of other central banks.

2.1 Monetary Policy Implementation in the United States

We begin by examining the total demand for reserve balances by the U.S. banking system. In our stylized framework, this demand is generated by a combination of two factors. First, banks face reserve requirements. If a bank's final balance is smaller than its requirement, it pays a penalty that is proportional to the shortfall. Second, banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank's final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a "precautionary" demand for reserves.